In this lesson, you will learn about generally accepted accounting principles (GAAP). You will learn the reason for the principles, their purpose, and how they relate to both corporate America and everyday people.

Buying an Entertainment Center

While walking through a furniture store, Kevin spots an entertainment center that he just has to have. He goes to the sales counter and inquires about buying the piece of furniture, only to be told by the salesman that the floor model can't be sold, but there is one unassembled one in stock. He tells Kevin that they will be glad to put the entertainment center together and deliver it to his home the next day, but Kevin is in a hurry. He decides to go ahead and purchase the unassembled piece of furniture and put it together himself. As long as he has directions to guide him through the assembly process, he shouldn't have any problem.

What Is GAAP?

Much like the directions that come with unassembled furniture, generally accepted accounting principles, or GAAP for short, are the directions that accountants use for properly preparing corporate financial statements. These directions are standards that are set by the Financial Accounting Standards Board (FASB). The FASB is a 7-member board that exists for the sole purpose of developing accounting standards. The main purpose for developing GAAP, and for making continual changes to the principles, is so that there will be uniformity among financial statements presented by corporations.

That does not mean that they will all be identical. Each business will have its own set of figures, but the format of the financial statements will be the same. This allows for comparisons to be made easily. It is important to note that GAAP are rule-based standards and considered the uniform standards that are accepted in the U.S. Other countries do not adopt the same standards. Instead, they use the International Financial Reporting Standards, which are based mostly on general principles.

Why Were GAAP Developed?

Back in the 1920s, the American economy was booming. Businesses were prospering, factories were being built to handle increased demand for products, and work was abundant. There was a general sense of laid back comfort in the investment and financial world. More people were sinking their hard earned savings into the stock market in hopes of capitalizing on the growth of the economy and getting rich quick. The stock market soared to its highest closing point ever on September 3, 1929, closing at 381.17. Two days later, the market started to decline at a slow and steady pace.

On Thursday, October 24, 1929, the price of stock plummeted. Investors became antsy, with many deciding to sell their stock. One group of investors decided to pool their resources and invest a hefty sum of money back into the stock market. They wanted the world to know that they believed stocks would rebound. On that day, stocks did rebound.

Four days later, on October 29, 1929, the sense of serenity about the stock market came to a screeching halt. On this date in history, now known as 'Black Tuesday,' the stock market crashed. Stock prices fell to unbelievable lows. Investors, in an attempt to save anything that they could, rushed to sell the shares of stock that they owned in various businesses. In all, on that one single day, 16.4 million shares of stock were sold. Many people lost everything they had in the stock market. Very few came out unscathed.

Turmoil on Black Tuesday

After the stock market crash, focus shifted from investing in stocks haphazardly to investing in the stocks of companies that appeared financially sound. The only way to examine the financial aspect of a company was to review the company's financial statements. It was during this time in the early 1930s that a committee was formed from members of the American Institute of Accountants to look closely into the financial reporting practices of corporations and improve upon them. It was from this committee that the seeds of GAAP were planted.

GAAP and the Financial Statements

In financial reporting, there are three main financial statements: the balance sheet, the income statement, and the statement of cash flows. GAAP guidelines provide the following specific rules for each of these three.

The Balance Sheet must include assets, liabilities, and equity sections.

The Income Statement must include revenues, expenses, and net income or loss.

The Statement of Cash Flows must include individual sections for operating activities, investing activities, and financing activities.

If the financial statements of a corporation are distributed to anyone outside of the organization, such as a private accounting firm, an auditor, or the IRS, then they must be prepared according to GAAP.

Lesson Summary

Think back to Kevin at the beginning of this lesson. He decided to put together his own entertainment center by following the directions, or guidelines, that accompanied the furniture pieces. He could have chosen to just put it together in any way that he saw fit, but would it be structurally sound? In the end, he chose to follow the guidelines given to him, and the result was a perfect piece of furniture that served the purpose it was designed for.

The same principle applies to GAAP and corporate financial statements. GAAP protocol is the blueprint for these financial statements that allows them to be uniform when presented publicly. This uniformity in the statements makes comparisons about financial health to be made much simpler, which is important to a potential investor.

Summary:

Earning College Credit

Did you know… We have over 160 college
courses that prepare you to earn
credit by exam that is accepted by over 1,500 colleges and universities. You can test out of the
first two years of college and save thousands off your degree. Anyone can earn
credit-by-exam regardless of age or education level.